What Is a Hedge?
A hedge is an investment to reduce the risk of adverse price movements in an asset.
Normally, a hedge consists of taking an offsetting position in a related security.
Defining Hedge in Simple Terms
Hedging is analogous to taking out an insurance policy.
If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance.
In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs.
There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains.
Put simply, hedging isn’t free.
In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout.
Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
How Does a Hedge Work?
In the investment world, hedging works in the same way.
Investors and money managers use hedging practices to reduce and control their exposure to risks.
In order to appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market.
The best way to do this is to make another investment in a targeted and controlled way.
Of course, the parallels with the insurance example above are limited: in the case of flood insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible.
In the investment space, hedging is both more complex and an imperfect science.
Hedging Through Derivatives
The most common way of hedging in the investment world is through derivatives.
Derivatives are securities that move in correspondence to one or more underlying assets.
They include options, swaps, futures and forward contracts.
Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined.
It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.
Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital.
Derivatives are not the only way to hedge, however.
Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one.